Global Economics

Stocks: Why Japan is More Worrisome than China

Global investors may be far too worried about the market risks from Chinese stocks—but unwinding the "yen carry trade" could prove bumpy

A lot of wealth has vaporized in recent trading sessions, as investors have been swept up in a wave of selling in global equity markets that started in China on Feb. 27. Sell-offs have moved across most of Asia, Europe, and the U.S, and some $1.5 trillion in market capitalization has been wiped out along the way.

Concerns about the quality of the so-called "sub-prime" U.S. home mortgage market, and even the possibility of outright recession in 2007, fed into the selling trend once it got rolling. But two of the biggest market risks are believed to be centered in Asia. The crucial importance of China's fast-track, $2.7 trillion economy to global growth, trade flows, and corporate profits has some worried about the negative impact of a sustained downturn in Chinese equities.

Then there is the equally disturbing prospect of a messy unwinding of hundreds of billions of dollars' worth of highly leveraged trades in risky emerging-market investments and U.S. dollar assets that have come from the ultra-cheap yen, thanks to rock-bottom Japanese interest rates in place since the late 1990s. This is a result of the so-called yen carry trade—in which investors borrow in yen, flip over into foreign currencies, and invest in non-Japanese bonds and stocks—that has been much discussed by market commentators and economists.

Yet how real are these risks—and to what classes of investments and markets exactly? Here is a quick background to guide investors through these highly volatile times in the global markets.

Why did China turn out to be the epicenter of the global stock turmoil?

It's richly ironic that the 9%-plus slide in the Shanghai & Shenzhen 300 Index that tracks local, currency-denominated mainland stocks had such a big impact on markets around the world. For one thing, its causes were entirely homegrown, nor all that surprising. Share prices at these two mainland markets had jumped 130% last year, and valuations were absurdly high. Analysts had been calling for a 15% to 20% correction for months.

These markets are largely powered by Chinese investors who aren't allowed to invest abroad, so they aren't influenced by trends in the U.S. or Japan. Nor do foreign investors have a huge stake in the so-called A-share market. The selling was mostly domestically driven and probably influenced most by the People's Bank of China move to raise—for the fifth time in eight months—the required cash reserves that lenders must park with the nation's central bank.

These moves are aimed at draining liquidity from the banking system and taming the growth in lending, which grew 16% year-on-year in January. True, the China stock market blowout was a shocker, but that same index fell 6.5% on Jan. 31 and has been ricocheting up and down in 3% swings all year.

So why did this local event have such a worldwide impact?

Timing is everything when it comes to global market psychology—and the Chinese stock declines came just as fresh worries were surfacing about the health of the U.S. and Japanese economies, the world's two biggest. After the troubles in China, and before U.S. markets opened up, came word of dismal durable goods data in the States. On top of that, reports said former U.S. Fed Chairman Alan Greenspan had suggested a recession was possible in the U.S. in 2007.

The result was a "perfect storm" of bad news that unnerved investors in the U.S., figures Jing Ulrich, head of China equity markets at JPMorgan (JPM) in Hong Kong. The sharp declines in the U.S. then boomeranged back to Asia and Europe—and stock markets have been highly skittish since. "There was a confluence of factors all happening on the same day," she explains.

That's very unlikely since, unlike U.S. households, most Chinese families have their money stashed away in bank deposits, not stocks. The investor class is growing rapidly, but the market shock isn't going to have a huge impact on the economy. China remains on course to grow 10% or so this year and likely will overtake Germany as world's third biggest economy in the same period.

One possible concern is that the Chinese government goes too far to stamp out asset bubbles in the stock and real estate markets, and restrictions on lending overshoot and really take a bite out of the economy. The mainland does generate a lot of growth through trade and capital flows.

China's two-way trade with the rest of the world hit $1.76 trillion in 2006, while its global trade surplus shot up 74%, to a record high of $177 billion. A number of economists see it in the $230 billion range next year.

So what's this yen carry trade business all about?

Since the late 1990s, the Bank of Japan, the central bank, has kept short-term rates pretty near zero and only raised them slightly to 0.5% in February. That has been a golden invitation for hedge funds and other institutional traders to raise yen funds cheaply and then buy better-performing bonds and other investments in emerging markets and elsewhere yielding 4% to 6%, or even more. The process of "carrying" or exploiting this pricing gap between two asset classes is where the name comes from.

Fine, so why should I care?

This is potentially more worrisome than the stock market rout in China given the vast web of linkages between the yen carry trade and the bond markets in rich world economies and all manner of emerging-market investments. Global investors have been unwinding their yen-financed bets aggressively in recent days, and that has added another layer of instability.

The yen has appreciated some 3% against the dollar since all this market trouble started. The reason is that investors are selling off bonds and stocks and paying back their yen loans. This process could feed on itself, because as the yen appreciates it takes more foreign currency to pay back those loans. Nobody wants to be the last one out the door.

Who would get hurt if this process gets out of control?

Lehman Brothers analysts Mingchun Sun and Rob Subbaraman in Hong Kong point out that developing Asian economies such as Indonesia and the Philippines are particularly vulnerable to the unwinding trend. They have "fairly high levels of external and public debt and among the lowest foreign currency reserves" in the region, both wrote in a note to clients on Feb. 28. Thailand could also feel some pain if the yen really spikes.

So could the export-driven Japanese economy. The Nikkei fell again on Mar. 2 and has lost 5.3% in the previous five trading sessions. Nobody really knows how big this yen carry trade is, since it doesn't show up in the official cross-border capital statistics. Some investment banks have estimated it could be in the $200 billion range, but there is a lot of guesswork behind such estimates.

So what would mitigate the market risks from China and Japan?

Well, a few months of less volatile trading would help. Again, China's economic fundamentals are robust, and that's what counts the most to global investors. An orderly correction that cools off exchanges in China would also be welcome.

At the same time, assuming Japanese interest rates continue to rise gradually, investors could reverse-engineer their yen-fueled trades in a less treacherous environment and the impact on emerging bond and stock markets would be far more benign. Here's to a little market serenity for the rest of 2007.